Too Much of a Good Thing: Morningstar Downgrades Arbitrage Fund

By Brendan Conway

Much like an overbought stock, a surge in assets under management in a fund is often bad news for investors. Grow quickly in a small niche and the manager is forced to engage in experimentation. It may or may not work out well for investors.

It’s great news for a fund manager, of course. The manager gets to earn bigger fees.

This worry isn’t far from Morningstar’s rationale this morning downgrading Arbitrage Fund (ARBFX), which invests in mergers and acquisitions, to “bronze” from “silver.” As Russel Kinnel writes, the fund had a “growth spurt” to $3 billion in assets from $500 million in three years, which “gave the fund a different growth profile.”

Translation: When a niche fund gets too big, its original strategy comes under stress.

From Kinnel:

Management has moved toward large caps in order to find more liquidity. As a result, it has gone to just 13% small-cap exposure from 40%. As small caps were big contributors to the fund’s success, that’s a worry.

It has also gone overseas to find more deals to satisfy that asset growth; the fund is now about half foreign. Thus, it is in a spot where there is less of a track record. So far the record on that move is disappointing as two of its three misfires on mergers came from overseas.

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